Tuesday, 9 June 2009

The top financial concern about retirement is not to run out of money. How can that be achieved? That's the question addressed in this book.

Author Moshe Milevsky, a finance prof at York University and one of the world's leading experts on pensions, insurance, and personal financial planning, has distilled the latest research and principles into a readable, non-technical guide for the proper way to select and balance financial products to achieve financial security.

His starting point is the demonstration that the person him/herself is the most important financial asset (You Inc) by far at the start of a working career due to the many years of salary ahead, which he terms human capital. I had a laugh at the You Inc analogy as he spun it out: "You Inc. will eventually consider merger opportunities, otherwise known as marriage. Marriage is the largest merger and acquisitions activity undertaken by You Inc. and may occur more than once." This light-hearted depiction leads to the quite serious demonstration that life insurance may be a highly worthwhile risk mitigation financial product when a lot rides on You Inc's human capital. He discusses the odds of living or dying at various ages and rules of thumb to decide whether life insurance is advisable or not and if so, how much is needed.

He covers in turn the importance of diversification, both across asset classes and internationally as a risk reduction method, He explains how non- or negative correlation are the mechanism that makes diversification work and extends that idea to You Inc by saying that people should think how their own human capital/job is linked to investment asset classes. Had I considered this ten years ago I would not have invested in shares of Nortel when I worked there - when the tech bubble burst my job loss was highly correlated with investment losses!

Milevsky's advice gets further from popular concepts when he looks at debt and concludes that debt in retirement is NOT necessarily bad. It may be good if it is used for investment where the return is greater than the cost of borrowing and where the borrower can withstand financial shocks and still pay the interest i.e. if you have the stable characteristics of a bond. He says a tenured professor such as himself at age 45 should have a 280% allocation to equity (i.e. have borrowed the amount over 100%) because he is a triple A bond. Along the way he trashes a common rule of thumb: "the age-old general rule that you should allocate your numerical value to bonds - or 100 minus your age value to stocks - is somewhat meaningless at best, and wrong at worst."

Three chapters are devoted to each of what he says are the key risks to financial security in retirement: inflation, longevity and sequence of investment returns (which is having a series of bad years near or at the beginning of retirement). Here again he debunks with a detailed example a common idea - the notion that one can best counter sequence of return risk by setting aside several years of cash to live off (what he calls the buckets approach) instead of maintaining a constant portfolio asset allocation. The failing of the buckets approach is that it does not withstand a prolonged bear market. One is reminded of the famous quote of John Maynard Keynes "The market can stay irrational longer than you can stay solvent." Irrationality can work both ways, optimistic or pessimistic.

When it comes to the latter chapters where he develops integrative solutions that consider all the risks and factors together, he proposes a unique and innovative way of calculating whether one is likely to run out of money given a spending rate (e.g. 5% of portfolio withdrawn each year) and investment assumptions (rate of return and volatility). Instead of the usual Monte Carlo simulation he has developed two equations, alpha and beta, that use the aforementioned inputs, along with median remaining lifespan (how long half the people your age will live according to mortaility statistics) to create a cross-table with varying probabilities of success.

Using a simple bond and stock portfolio, Milevsky performs other calculations that show that the optimal asset allocation whether a person is 55, 65 or even 75 is about 60 to 70% equity. He explains this as the result of the higher long term rate of return on equities more than counter-acting their high short-term volatility.

The concluding chapters present the essential characteristics of annuities and show how to combine them with an investment portfolio to control the three retirement risks. He differentiates standard (not inflation-indexed) lifetime payout income annuities (LIPA) from those which provide riders for a guaranteed withdrawal benefit (GMWB) or a guaranteed income benefit (GMIB). The final bits of integration include retirement goals: liquidity for unforeseen expenses, estate bequests and prevention of behavioural mistakes (i.e. if you have an annuity you are locked in and cannot mess things up but if you have a portfolio it is easy to make all those investing errors of judgement).

Not so much a final answer as a way of thinking about things, this book broadens one's perspective to a holistic view of assets with financial value. It provides invaluable insight and tools for an individual to understand how to cope with various financial risks throughout life.

The final table in the book, table 11.2 is a chilling assessment of the amount of financial wealth required to sustain an income level when guaranteed government pensions and/or private defined benefit plans will only provide a small portion of the needs. Planning to withdraw from a portfolio at a 5% annual rate or even a 4% rate, which is that most commonly cited as providing indefinite sustainability, still means in his opinion that one should buy a substantial amount of annuities to protect against longevity and sequence of returns risk.

Quibbles:

the USA is used as the context throughout, with references to US inflation and mortality statistics, US market returns, US retirement plans like 401k and IRA; Milevsky is a Canadian teaching at York University and he uses a lot of the research he and others have conducted at the IFID center in Toronto (where if you wish to do so you can obtain most if not all this book's content for free download, though it is not organized and structured with the convenience of the book); admittedly such references are not material to the principles he expounds in the box since,

tax optimization is not considered (he deliberately and explicitly sets it aside) - after-tax returns, which is what a retiree investor cares about, may differ greatly with the same investment portfolio size; whether income comes from a tax-deferred account like RRSPs and LIRAs or is tax-advantaged like dividend income, matters a lot. $5000 of interest pulled from an RRSP taxed at a marginal 30% rate is only $3500 in spending, while $5000 in dividends in a taxable account to a taxpayer in the same 30% bracket in Ontario pays about 7% tax, resulting in $4650 available to spend. That's why this book's contribution is not a final answer but a useful set of principles.

asset classes are ultra-simplified to "cash (US T-bills), stocks (US S&P 500) and bonds (US aggregate)" from which is taken the investment portfolio assumption used throughout - stocks give off 7% average (arithmetic mean) annual return with 20% volatility; the beneficial effects of further diversification with real estate, international equities and bonds, commodities, real return bonds are not examined.

high spending rate assumptions; everywhere the book uses high spending rates in retirement from 5 to 9%; it would be helpful to have shown the 4% rate in the sustainability tables on pages 135-6. As it turns out there is such analysis in Milevsky's 2007 paper A Gentle Guide to the Calculus of Sustainable Income on the QWeMA website. QWeMA is the company set up and headed by Milevsky to market his research ideas and turn them into tools for insurance and investment companies. This led me to the Manulife Retirement Solutions Center where the Milevsky's ideas are being put into practice to inform advisors with a variety of video clips and short background information (it is telling that this simplified information is prepared for financial advisors!). It features a free to use online product allocation tool where you can plug in your own numbers, fill-in budgeting worksheets and a retirement savings calculator whose results you can print. They even use Canadian facts and figures.

sensitivity analysis is not performed; since one cannot know if the future will repeat the past in financial markets, the section on the effect of asset allocation on sustainability of spending rates would be more convincing if various return and volatility scenarios showed the same result. The Gentle Guide paper provides such data in tables 3 and 4 showing how dramatically a reduction of volatility can reduce chances of ruin - with 23 years of retirement ahead at a 7% expected portfolio return, the chances of ruin fall from 15.1% to 3.0% which seems to suggest that one's problem can be solved by diversification ... but the same table shows that if returns disappoint for the whole period at only 5%, the likelihood of ruin only falls from 27.5% to 8.8%, which is only on the edge of safety as far as I am concerned. The numerical assumptions are critical! One cannot merely trust the past averages to repeat themselves.

the product allocation algorithm is not revealed and is proprietary (to QWeMA) - what is the magic and art being concealed one wonders

preservation of human capital aka working part-time in retirement should form an active part of retirement financial planning. One doesn't suddenly go brain dead and become physically incapable the day after pulling the plug on full-time employment. It was instructive to learn from my daughter the new doctor that some recently retired physicians decided to mitigate the recent bad sequence of returns of the financial crisis by going back back to work temporarily doing locums. The book mentions the possibility of prolonging work but doesn't analyze the effects. Every dollar earned saves a dollar coming out of a retirement portfolio, in effect reducing the withdrawal rate, which much prolongs a portfolio's sustainability.

cutting back on spending is a very effective wealth preservation method and when it comes down to the crunch, a lot of spending that is deemed necessary becomes discretionary. That's why few people actually ever run out of money, they just keep downsizing their lives.

yearly iterations and repeated re-consideration of plans is not discussed, yet circumstances will change. Retirement finances shouldn't be done as a one-time forever decision. Optimal product allocations may shift back and forth.

Milevsky also mentions a few other topics he feels should be included in a complete financial plan:

consideration of life insurance for maximizing a estate value

use of home equity loans or reverse mortgages as another "product"

long term care insurance to control risk from health

The bottom line is that this book helps you figure out whether you are in the "no hope", the "no worries" or the "no guarantees" zone of retirement sustainability. If it is the latter, I am convinced by the book that annuities should form part of a financial arrangement for retirement.

Read this book if you want, as you should in my opinion, to take any hand in planning and constructing your financial future as you enter retirement. Its short 200 pages are rich in high-value, well-explained, well-illustrated content.

Despite my extensive quibbles, some of which (taxes, sensitivity analysis on assumptions) I think are quite important to constructing an actual plan, this book sets out such important and powerful principles that I have to give it my highest rating, five out of five stars.

3 comments:

Anonymous
said...

I had hoped you would review Milevsky's book. And viola, an insightful and critical treatment! I purchased it specifically for the annuities information. As you point out, this book is definitely geared to the US market.

Thanks also for the links to his 2007 paper and the Manulife Retirement Solutions Centre. I think they will be valuable to look at and explore. I'll probably tuck a copy of your review in the book to help guide me when I finally do get to read it.

On a more general note, I would like to say thanks for the time and effort you put into your blog. When I first discovered the world of personnel finance blogs yours was the first I came across. I was awe struck to think all this information was suddenly available to me. I literally read it back to 2007 over several weekends. Your posts were inspiring and empowering. I particularly appreciated your level of research and your eye for detail. You always leave me with something new.